By Paola Compés Tatay, ESG Specialist
As a Venture Capital firm, we understand that our investment decisions have an impact on the environment and society and that such considerations can’t be ignored. While our focus is to provide the best return on investment to our limited partners, we believe that we can carry such duty with responsibility and integrity. The three most important letters in this discussion: ESG.
Recently, the term has come under fire by certain interest groups. Companies as well as investors are struggling to implement ESG rules consistently. Some have even suggested relabeling ESG entirely.
I would like to demystify some of the misconceptions about ESG in this article. Let’s start by asking whether we should talk about ESG at all. For that, we should discuss where the term comes from, how it affects business and investors, and why changing the name to avoid a necessary discussion won’t appease critics.
A broad term under scrutiny
An abbreviation of Environmental, Social, Governance, the term ESG has remained relatively unknown to the public for many years, despite being implemented for over a decade in the public markets for due diligence purposes and active management during the holding period.
Now, with the EU Green Deal in Europe and proposed regulation across the globe calling for higher transparency by companies and duty of supervision from investors, the term is trickling down from the asset owners to all the asset management classes, including Venture Capital and, consequently, its active oversight over its portfolio companies. With its increasing popularity and applicability – after all, early-stage ventures are as small as a company can be – the term has begun attracting high levels of scrutiny and, at times, politicizing.
So much so that in some states in the US, there are already proposals to ban asset owners from considering ESG. Following such a proposition by the Republican governor of Florida, Ron DeSantis, in March 2023, the media company Climate Power and think tank Data for Progress conducted a national survey querying respondents’ attitudes towards ESG investing and other analog terms. Results were definite: While the ESG investing term received 30% votes between very favorable to somewhat favorable attitudes, “freedom to invest” and “responsible investment” received, respectively, 68% and 66% votes. But perhaps most importantly, most voters have never heard about ESG. Similarly, when the London-based ESG in VC initiative posted a LinkedIn poll asking its followers if the term ESG had an image problem, 83% replied yes.
These results lead to two conclusions: the public doesn’t even know what ESG is in the first place, but interestingly, they are not opposed to the idea of investors having responsibilities – beyond purely monetary value creation – in the first place. I won’t get into “freedom to invest” as it is, in my opinion, too obscure and intangible for a definition.
This begs the question, has the time come to relabel ESG and call it something completely different? To answer it, we need to define what ESG is in the first place as the survey shows this may be the starting point of this dilemma.
What ESG means for investing
ESG has long been mistaken for philanthropy or investing in uniquely mission-led companies, but it originated closer to home—in the financial industry. In 2004, the United Nations invited AXA Group, HSBC, Banco do Brasil, Deutsche Bank, and other multinational market capital players with over $6 trillion assets under management “to develop guidelines and recommendations on how to better integrate environmental, social and corporate governance issues in asset management, securities brokerage services and associated research functions.”
The final report, Who Cares Wins, had two central hypotheses:
- Looking beyond purely financial metrics is fundamental to a better understanding of an investment’s risks and opportunities, and ESG considerations are “part of companies’ overall management quality needed to compete successfully” and
- a business that acts responsibly toward its stakeholders and the environment is a business that also wins in the long term.
ESG isn’t only (or first and foremost) a moral and ethical layer laid into business activities. Rather, it helps investors do what they’ve always done: Analyze the risks and opportunities associated with an investment to determine its value and market resilience. Hence, the consideration of ESG issues that are critical for a company’s success is, simply put, investing.
For example, when an investor analyzes a company’s supply chain to assess labor conditions (part of the “S” in “ESG”), especially in countries without robust labor regulation in line with the International Labour Organization’s guidelines, they aren’t only concerned with ethics—they evaluate the reputational risk that the company exposes itself to. This was the case in 1996 when Life Magazine published a report on child labor featuring a photo of a 12-year-old Pakistani boy sewing a Nike football. The scandal had a tremendous impact on Nike’s reputation and bottom line. Similarly, (now visiting the “E” in “ESG”) a company with large infrastructure or supply chain reliances in geographies with a high risk of extreme weather may be exposed to physical challenges and high insurance costs that would be crucial to assess prior to investing.
Dismissing this data could arguably lead to critical blind spots and missed business opportunities, resulting in billions of dollars in losses, especially when the customer base contractually demands observance of ESG and reporting. That’s why Arizona, initially among the states supporting the anti-ESG alliance’s proposals, has dropped its backing.
The unresolved challenges of ESG
As an umbrella term that covers a broad array of considerations, it’s difficult to illustrate ESG in a concrete, accessible form. Most importantly, it makes it tricky to measure in a comprehensive and final framework —an issue repeatedly flagged when discussing the shortcomings of ESG ratings.
After all, the term would cover all environmental aspects that could affect a company and vice versa, how a company interacts with its employees, stakeholders, and community, and which governance mechanism it adopts to prevent illegal acts or failure to comply with recognized international standards representing business best practices, such as the OECD Guidelines for Multinational Enterprises.
Most importantly, research shows that the positive effects of considering ESG factors are achieved when material issues are considered and addressed, not necessarily all the potential ESG metrics at the same time. For example, extended periods of drought will have a more material weight for the viability of an agricultural company versus a B2B SaaS one. This means that each company, depending on their sector, geography, stage of development, etc. will have different elements to address making comparability and simplification an ineffective – and potentially largely bureaucratic – exercise.
Additionally, there is much discussion about what considering ESG factors would mean for the fiduciary duty that investors have towards their limited partners. Critics argue that considering other factors beyond financial performance would lead to a breach of the fiduciary duty of investors, whose primary responsibility is to maximize shareholders’ returns. However, bodies such as the UN’s PRI (Principles for Responsible Investment) group have contested this assumption, advocating for a modern interpretation of the fiduciary duty. This should take into account a challenged environment and a change in investor requirements which is evidenced by an increased interest in sustainability by younger generations.
Finally, a strong voice of criticism sustains that observing ESG metrics harms performance by placing constraints on the portfolio and creating additional obligations for organizations leading to an infective and distracting use of resources. A recent piece of research by PitchBook rejected this theory after analyzing funds subscribing to the UN’s PRI (Principles for Responsible Investment) versus non-signatories. Interestingly, and also deserving its discussion, member signatories did not perform better than non-signatories concluding that there is no evidence that PRI signatories differ in performance from their peers in a statistically meaningful way.
Why simply relabeling won’t help
As we have seen above, while some of the challenges faced by ESG are easier to tackle – for instance, more standardization – others are complex and nuanced, they go back to the conception of fiduciary duty during the last century, questions at a broader scale whether corporations should be accountable for their impact to society and the environment at all, as well as to what extent state oversight is prudent and productive.
In a time with growing inequalities around the globe, the recovery from Covid-19, and an unparalleled climate crisis created by human activity, the conversation is bound to evolve from where we were 20 years ago. As our world is constantly changing, so do societies’ expectations of the role of state actors.
This cannot simply be fixed by erasing the term ESG and replacing it entirely with one of the terms aforementioned by the Data for Progress survey, i.e. responsible investment or freedom to invest. In my opinion, the way forward is further research, standardization of frameworks and metrics, practical experience with consequential data insights, and stakeholder engagement to understand what the public expects from the use of their money.
ESG: A framework for responsible investing
At Project A, we believe that following proper due diligence and motivating companies to perform well beyond financial metrics is imperative for a society that recognizes companies’ power and impact on people and the planet. And this applies to any organization, regardless of whether they are mission-led or not. For that reason, in addition to pursuing the best financial results for our investors, we are working hard to apply an ESG lens to everything we do, as a company and as responsible portfolio managers.
Still, we don’t shy away from closely following the conversation about the merits of ESG and its challenges, collaborating with industry leaders and peers to advance the conversation as we believe that observance of non-financial metrics – captured within ESG frameworks – is the future of the European financial industry.
In the next article, we’ll discuss what ESG and responsible investment means for Project A, its practical application in the early stage, and how we aim to work with our portfolio companies to ensure it remains a value-added exercise.
Want to learn more or discuss this in the meantime? Reach out to me on LinkedIn.